A defining trait of SMI’s strategies is that they follow objective rules. They don’t depend on predictions or subjective judgments about how the stock market will perform. Instead, they rely on momentum, a remarkably simple metric that has guided SMI’s investing strategies for more than three decades.
This article takes a closer look at momentum — what it is, how it functions, why SMI adopted it, and how we incorporate it into our strategies.
A fundamental mistake many investors make is moving too quickly in choosing investments. They read about a hot stock or this year’s best-performing mutual fund and jump in. It’s all very ad hoc and reactive.
A better approach is to first choose a good investment strategy and allow it to guide you to the best investments. In other words, when deciding what to invest in, your strategy matters. And a good strategy is driven by a systematic, comprehensive process for determining what investments to purchase, how long to hold them, and when it comes time to make a change, what new investments to buy.
The best investment strategies are marked by: 1) objectivity, 2) clarity, 3) a good track record, and 4) ease of implementation. Since its founding in 1990, Sound Mind Investing has delivered strategies that meet those criteria with the help of a simple yet powerful indicator known as momentum.
Recent past is prologue
Momentum is the idea that recent past performance tends to continue — that is, it usually persists into the near future. Mutual funds that have done well in recent months often keep performing well, while those with poor recent results tend to continue performing poorly.
Think of it as Sir Isaac Newton’s first law of motion applied to investing: “A body in motion tends to stay in motion unless acted on by an outside force.”
This may run counter to something you’ve heard many times — that “past performance is no guarantee of future results.” So, relying on a strategy that assumes past performance will continue may make you cautious. All investment prospectuses must include the “past performance” disclaimer, and for good reason. Past performance clearly doesn’t promise future returns, and an investment’s longer-term past performance (3-, 5-, or 10-years) has been shown to have virtually no predictive value.
That’s why mutual-fund rating systems that rely on those metrics, such as Morningstar’s star rankings, have proven to be such poor guides to choosing funds. According to a Wall Street Journal article, “Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating.”
Still, such ratings are very influential in how many investors choose which funds to invest in. So influential, in fact, that a 2024 paper written by professors from Harvard, Boston College, and MIT said that some fund managers are finding ways to game the Morningstar system to garner higher ratings.
Fortunately, there’s a better way to select funds: Momentum. The fact is that an investment’s recent performance, particularly how it has done over the past 3-12 months, has been shown to strongly predict its near-term future performance.
A long, well-researched history
Long before it became known as “momentum investing,” this idea got the attention of British economist David Ricardo (1772-1823). A respected thinker often mentioned along with well-known classical economists such as Adam Smith and John Stuart Mill, Ricardo was also a successful investor. As Wall Street Journal columnist Jason Zweig has noted, Ricardo built a fortune by adhering to certain “golden rules,” such as, “cut short your losses” and “let your profits run on.”
That’s a solid basic description of trend-following, which is what momentum investing is — investing in a stock or mutual fund whose performance is trending positively, staying with it until its momentum begins to wane, and then moving on to a stronger-performing investment.
Momentum is such a simple idea that its effectiveness may seem surprising. After all, there are countless more sophisticated investment ideas in use today — from highly analytical ways of identifying undervalued companies to looking for the convergence of multiple patterns in performance charts. And yet, momentum’s simplicity is one of its strengths. If you’re going to put money entrusted to you by God at risk in the stock market (every investment involves risk), it’s a mark of good stewardship to use an investment strategy that’s as easy to understand as it is effective.
A strategy that makes sense
Think of it this way. As the football season hits the midway mark, which teams are most likely to make it to the Super Bowl — the teams that have won the most games over the past five years or the teams that have won the most games recently? Of course, it’s the teams with the best records this year. The same is true with investments, such as mutual funds.
But momentum investing doesn’t just make intuitive sense. Its effectiveness has been proven in many research studies. In 1993, Emory University economics professor Narasimhan Jegadeesh and University of Texas economics professor Sheridan Titman looked at a strategy that “selects stocks based on their past 6-month returns and holds them for 6 months.” Their paper is one of the best-known studies about momentum investing. It concludes, “Trading strategies that buy past winners and sell past losers realize significant abnormal returns.”
Since then, the topic has attracted a lot of academic interest. According to one estimate, between 1993 and 2019, over 500 momentum investing studies were published. In 2014, when global investment-management firm AQR scanned the vast landscape of momentum research, it found, “[Momentum’s] return premium is evident in 212 years of U.S. equity data (from 1801 to 2012) — as well as U.K. equity data dating back to the Victorian age, in 40 other countries and in more than a dozen other asset classes. Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets for as long as there have been markets.”
A more recent summary of 159 years of data found that, “The evidence supporting momentum [investing] is about as strong as you’ll find in finance.”
The premiere anomaly
Even University of Chicago economist Eugene Fama, whose life’s work would seem to refute the possibility that momentum could be effective, has found himself at a loss to explain how momentum could work so well, yet he is convinced it does.
In 2013, Fama was awarded the Nobel Prize for his work on the Efficient Market Hypothesis (EMH), which argues that stocks always trade at their fair value because information about them is quickly and efficiently factored in to their prices. Therefore, according to the theory, it’s pointless to search for undervalued stocks or to look for trends that would lead to outperformance.
However, Fama has acknowledged several “anomalies” — strategies that defy what would be expected from a purely efficient stock market. As he and Dartmouth finance professor Kenneth French wrote in a paper they co-authored in 2008, “the premiere anomaly is momentum. Stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns” (emphasis added). More recently, Fama went so far as to call momentum “the biggest embarrassment to the efficient market hypothesis.”
Why momentum works
Of course, the stock market is made up of individual market participants — people, who are often far from efficient or rational. In an ironic nod to that reality, in the same year that the Nobel Committee honored Eugene Fama for his Efficient Market Hypothesis, it also awarded the same prestigious prize to another economist, Yale’s Robert Shiller, whose work highlights just how inefficient the market can be.
In the run-up to the financial crisis of 2007-2008, Shiller sensed that excessive optimism had driven too many people to buy homes they could not afford, creating a housing “bubble” that, if it were to burst, would cause painful consequences. Sure enough, many thousands of people lost their homes to foreclosure and several major financial institutions either went out of business or had to be bailed out by the federal government.
Surprisingly, the willingness of economists to consider emotional factors as drivers of financial decisions is relatively new. Shiller credits the blending of psychology, sociology, and political science into economics for “bringing economics into a broader appreciation of reality.”
One of the foremost social scientists to call attention to the often irrational realities of economics was Daniel Kahneman, a psychologist whose work was instrumental in the development of what is now known as “behavioral economics.” The field traces its roots to the 1970s when Kahneman and psychologist Amos Tversky began a long collaboration that explored the many cognitive biases that drive so much human behavior.
It is within this field of behavioral economics where momentum may be best understood. In particular, two cognitive biases may explain why momentum works: conservatism and herding. With conservatism, people react slowly to new information — for example, investors respond to good news about an investment they hold by gradually continuing to invest more. Herding is when investors see others making a particular investment and join in. Both behaviors can fuel an upward trend in the price of an investment.
Systematizing momentum
Not much is known about how David Ricardo decided when to cut short his losses or how long to let his profits run on. However, in order to move from a philosophy of investing to a reliable, executable strategy, more specifics are needed. Objective ways of quantifying momentum are required so that investors know when an investment’s momentum is strong enough to justify its purchase and when that momentum has weakened to the point of making it prudent to sell.
Ben Carlson, author of the book A Wealth of Common Sense and a blog by the same name, put it this way: “It is a terrible idea to chase performance if you don’t know what you’re doing or why you’re doing it. Momentum is chasing performance, but in a systematic way, with an entry and exit strategy in place. This is why the best momentum investors use a rules-based approach.”
The development of SMI’s momentum strategies
In 1980, SMI founder Austin Pryor was a money manager enjoying success following the principles of market timing, moving client money into and out of the market based on anticipated market strength or weakness.
His firm’s success continued for many years, but in the latter half of the 80s, the bottom fell out. In the spring of 1987, with the Dow Jones Industrial Average at about 2,300, Austin and his business partner believed the market had risen too far too fast, and put all of their clients’ money into money-market funds. When the Dow kept rising throughout that summer, many clients, disappointed with missing out on the continuing rally to above 2,700, took their money elsewhere.
On Oct. 19, 1987, the market crashed. Now known as Black Monday, the Dow dropped more than 22% that day to below 1,750. Austin’s earlier move to safety was vindicated, but none of the lost clients returned.
It was a painful time that led Austin into an extended period of praying for God’s direction. An answer came in the fall of 1989 over lunch with good friend Larry Burkett, a prolific biblical money-management author and host of a popular nationally syndicated radio program. Larry told Austin the Christian community needed a monthly investment newsletter to guide them through the investing process with clear instruction and biblical counsel.
While Austin readily agreed that such a publication would be beneficial, it didn’t initially occur to him that he should create it. But in the weeks that followed, he felt the Lord’s encouragement to take up the challenge, and he launched Sound Mind Investing in July 1990.
Given his more than 10 years of experience as a market timer, one might think he would incorporate that focus into his newsletter venture. However, he recognized that a “trading” approach would require more direct coaching than could be provided through a monthly print publication. Additionally, to effectively use such a system, a subscribing investor would need a great deal of time, flexibility, and self-control. So, in contrast to the emotionally challenging, short-term mindset of market timing, Austin decided to emphasize the wisdom of taking a long-term perspective. As Proverbs 13:11b says, “He who gathers money little by little makes it grow.”
He also knew from experience that the use of objective, mechanical rules to guide one’s investment strategy provided a needed guardrail against emotional decision-making. From the outset, Austin based SMI’s investment recommendations on momentum, an approach he had used in varying degrees in managing his clients’ assets.
He was especially intrigued by an approach to momentum investing used by Burton Berry, founder of a mutual-fund newsletter called NoLoad Fund-X. However, given that SMI was initially designed to appeal to novice investors, Austin devised a somewhat simplified version of Berry’s approach that would involve less buying and selling. That led to SMI’s first momentum investing strategy, Fund Upgrading.
SMI’s momentum strategies today
Fund Upgrading continues to be one of SMI’s “core” strategies, meaning it can be used to manage an investor’s entire portfolio. To follow Upgrading, investors first take SMI’s risk-tolerance questionnaire (found in the Start Here section of the SMI website). Then they combine those findings with their investment time frame to come up with an optimal asset allocation — that is, the mix of stocks and bonds that’s appropriate for them.
If the investor’s optimal asset allocation is 100% stocks, the portfolio is divided as SMI recommends among funds in three stock-risk categories: Small Company funds, Large Company funds, and a “Situational” category that includes foreign, commodities, and other types of funds. If their optimal asset allocation calls for the use of bonds, that portion of the portfolio is invested across four bond funds.
Within each of the stock categories, the momentum scores of hundreds of funds are evaluated each month. The recommended funds, other than one fixed fund, are those with the highest momentum, calculated simply by adding together a fund’s most recent 3-, 6-, and 12-month performance. For example, if a fund has lost -2.0% over the past 3 months, gained +4.5% over the past 6 months, and gained +7.0% over the past 12 months, its momentum score would be 9.5.
Notice that the most recent three-month’s performance is reflected in all three figures. It represents 100% of the first number, 50% of the second number, and 25% of the final number. In this way, a fund’s most recent performance is given greater weight. This formula reflects SMI’s experience that (1) the older the performance data, the less relevant it is, and (2) more recent months should be weighted more heavily than distant months.
As long as a recommended fund’s momentum score keeps it within the top 25% of all the funds in its risk category, it remains a recommended fund. Once it drops below that top quartile, it is replaced with the then highest-momentum fund. This approach to using momentum is known as relative momentum. That means the performance of a fund within a given category is compared to other funds in the category.
Over time, SMI’s ongoing research has resulted in several improvements to Fund Upgrading. In early 2018, for instance, new defensive protocols based on the principles of absolute momentum were added to the Fund Upgrading strategy. Recommended funds are still chosen by comparing a fund’s performance against all others in its category. However, one aspect of the new protocols is to compare each fund’s momentum with its own recent past performance. This process will objectively help investors move out of particular stock funds and into cash if a steep and persistent negative (bearish) trend occurs.
For the next two strategies, the momentum formulas used to rank funds vary somewhat from that employed for Fund Upgrading, but the same principles drive each of them.
Sector Rotation, launched in 2003, is a high-risk, high-reward strategy that has delivered impressive long-term returns. Although SR’s peaks have surpassed those of all other SMI strategies, its valleys have been deeper (see SR’s historical performance data here). Due to the strategy’s volatility, we recommend that investors allocate no more than 5%-15% of their total portfolio to SR.
With Sector Rotation, SMI monitors the momentum of over 100 concentrated “sector” funds, such as those that invest only in telecommunications or bio-tech companies. As with Fund Upgrading, after the fund at the top of the list is first recommended, it is held until its momentum drops it below the momentum of the top 25% of funds in the SR universe. At that point, it is replaced with the sector fund currently at the top of the rankings.
Dynamic Asset Allocation is the most recent SMI momentum strategy, introduced in 2013 to add a more defensive strategy to SMI’s lineup. Like Fund Upgrading, DAA is a core strategy, suitable for managing an investor’s entire portfolio. However, whereas Fund Upgrading is a strategic asset-allocation strategy (an investor’s portfolio is designed around their optimal stock/bond allocation, with momentum dictating which particular stock funds to hold), DAA is a tactical asset-allocation strategy. In addition to one fixed fund, it rotates investors among six broad asset classes (U.S. stocks, foreign stocks, real estate, bonds, gold, and cash), each one represented by one or two exchange-traded funds.
Those categories were chosen because they tend to be less highly correlated with each other. In other words, if some are performing poorly, others are likely to be performing better. Investors following the strategy invest in the three asset classes showing the highest momentum.
While Fund Upgrading and Dynamic Asset Allocation could be used to manage your entire portfolio, perhaps with a relatively small allocation to Sector Rotation, SMI research has demonstrated that the use of all three strategies may be the best approach overall, lowering overall portfolio volatility while increasing returns. SMI’s generally recommended approach to this is “50/40/10” — 50% DAA, 40% Fund Upgrading, and 10% Sector Rotation.
SMI also offers an indexing strategy, Just-the-Basics, that doesn’t utilize momentum. It’s a good choice for investors who are just getting started with investing, have relatively small portfolios, or are investing through a taxable account.
Necessary cautions
Historically, the biggest arguments against momentum investing have had to do with the perception that it requires frequent trading, and as a result, generates excessive trading costs. There are many iterations of momentum investing, and while some may involve repeated trading, one of SMI’s guiding principles in constructing our strategies has been to provide compelling performance while minimizing trading.
Although momentum investing has an impressive long-term record, it can go through periods of underperformance — especially at market turning points. As a trend-following approach, momentum positions investors in what is working now. When a trend changes, it takes a little time to adjust a portfolio to the new trend.
These points are evident in DAA’s back-tested performance during the 2007-2009 bear market. Over the course of those tough 16 months, DAA would have lost money in 10 of them. However, because of the way the strategy responded to the changing market trends, DAA would have lost only -1.4% during that entire bearish period when the stock market was ravaged by a -51% loss!
Conclusion
Successful long-term investing doesn’t begin with trying to select good investments. It begins with selecting a solid strategy and letting it tell you what to invest in. The best strategies are driven by an objective, rules-based process. With momentum at their core, SMI’s Fund Upgrading, Dynamic Asset Allocation, and Sector Rotation strategies are built on an objective metric that’s been helping investors succeed for more than 200 years.
Taking advantage of the “anomaly” of momentum is an effective way to grow your financial resources over time, thus helping you make the most of what the Lord has entrusted to you.
